From the July 1997 issue of Entrepreneur

The key to surviving an IRS audit: Know the rules.

What are the two words that taxpayers dread the most? That's right--"IRS audit." Now consider facing this daunting ordeal without the comforting presence of your tax advisor.

This is exactly the position June Langhoff found herself in on January 23, 1996, when her homebased business deductions came under question by the IRS. Langhoff is the owner of Softwords, a business writing and communications company she has run from her Pacifica, California, home for 15 years.

After an initial bout of panic when she received the audit notice and found that her tax advisor was not available to help, Langhoff gathered what she'd need to support her claims on the 1994 return. Armed with photos, receipts, work she'd done and more, Langhoff arrived at the IRS office prepared for the worst. Two hours later, she walked out owing only $225 and feeling pleasantly surprised.

Stating Her Claim

Langhoff's home office deduction sent up a red flag to IRS investigators. She had to demonstrate that her home office is the principal place where her business's income is generated. In other words, you can't just do your billing or open mail there.

"You can take the home office deduction if the location is used exclusively and regularly for the business," says Phil Bergstrom, a CPA and manager of professional services for American Express Tax and Business Services in Minneapolis. "It's not a good idea to have a television in there--unless you're a TV critic."

The office doesn't necessarily have to take up an entire room; it can be a portion of a room. Arranging your file cabinets to divide the office from the rest of the room provides a clear separation and could help in the event of an audit.

To prove her home office deduction was legitimate, Langhoff showed the IRS auditor photos of her built-in bookcases, wrap-around desk, computers, printer, backup disk drives, phone and modem. She also included a letter that strengthened her case. "In 1994, I did some subcontracting work for a company that gave me a letter saying all subcontractors were responsible for their own office space, supplies, etc.," she says. "I thought it might be helpful [someday], so I hung on to it."

Another item on Lang-hoff's business tax return that had the auditor diving for his calculator was the $1,242 she spent on books. She showed the auditor photos of her extensive library and then produced receipts for all the books. "About halfway through, he said, `It looks like you spent $1,200.' "

Warning Signs

Homebased businesses most likely to come under close IRS scrutiny are those where large amounts of currency flow in and out, according to Bergstrom. "They're looking for unreported income," he says.

Uncle Sam also reviews your expenses to make sure they are in line with industry norms, says Bergstrom. It makes sense for a lawyer working from a home office to entertain clients in fancy restaurants and incur travel or publication costs, for example, but those same expenses might not make sense for a homebased telemarketer.

If you disagree with the auditor's assessment of your expenses, you can appeal in writing to the IRS. "You appeal to an independent division of the IRS whose role is to solve cases so the tax agency doesn't have to go to the expense of litigation," explains Bergstrom. "Appeal officers have the most authority to decide your case."

In the end, Langhoff's experience was not nearly as traumatic as she expected. "My auditor was there to help as much as [to obtain information]," she says.

Bergstrom agrees. "IRS people deal with rules and to some extent are restricted," he says. "Saying `This is the rule, this is what I did, and therefore the results should be X' is the best way to go."

Contact Sources

American Express Tax and Business Services , 733 Marquette Ave., Minneapolis, MN 55402, (612) 671-8205;

Softwords , 380 Seaside Dr., Pacifica, CA 94044, jlanghoff@aol.com